What it means
Every business spends money, but not all expenses react the same way when business gets busier or slower. Some expenses stay completely flat no matter how much you sell, while others rise and fall in direct proportion to your sales activity.
Separating these costs is vital for accurate budgeting and forecasting. Expenses generally fall into three main buckets: fixed, variable, and mixed.
Fixed costs, like your monthly office rent, remain unchanged regardless of your output. Variable costs, such as raw materials, increase as you produce more items because each sale requires more inputs.
Mixed costs contain elements of both, such as a utility bill with a base connection fee plus usage charges. For non-finance managers, knowing how costs behave prevents nasty surprises.
If you assume all costs are fixed, a surge in sales might leave you short of supplies. Conversely, if you think all costs scale with sales, you might misjudge your profit margins.
Analysing cost behaviour allows you to calculate your break-even point and make confident decisions about pricing and expansion. Think of a mobile phone plan.
Your monthly line rental is a fixed cost that you pay even if you make zero calls. The extra charges for data overages represent variable costs that grow the more you use them.
In practice
Real-world examples
Example 1
As a freelance graphic designer, your monthly website hosting software fee is a fixed cost of $30, while printing costs for client brochures rise by $5 for every job you complete. In a month with 10 jobs, your total is $30 + ($5 x 10) = $80. In a month with 20 jobs, it is $30 + ($5 x 20) = $130, so doubling your work raises costs by far less than double.
Example 2
For a local bakery, the monthly oven lease is a fixed cost of $800, whereas the flour, butter, and sugar costs go up by $2 for every loaf of bread baked and sold that week. Baking 1,000 loaves costs $800 + $2,000 = $2,800, an average of $2.80 per loaf. The owner knows that every extra loaf adds only $2 of cost, which helps when quoting a large wholesale order.
Example 3
A regional courier company pays $2,000 per month for vehicle insurance, while fuel costs rise and fall depending on the total distance driven by drivers making daily deliveries. At $0.50 per mile, a busy month of 10,000 miles costs $5,000 in fuel, giving a total of $7,000. A quiet month of 6,000 miles costs $3,000 in fuel and $5,000 in total, because the insurance does not change.
Think of it
Think of a mobile phone plan. The monthly line rental is a fixed cost you pay regardless of use, while text message charges are variable costs that increase the more you chat.
Formula
Calculation
Total Cost = Fixed Costs + (Variable Cost per Unit x Number of Units)
Worked example 1. A bakery has fixed monthly rent of $1,000, and it costs $2 of ingredients to bake a cake. Making 500 cakes gives Total Cost = $1,000 + ($2 x 500) = $1,000 + $1,000 = $2,000, so the average cost per cake is $2,000 / 500 = $4.00. Making 1,000 cakes gives Total Cost = $1,000 + ($2 x 1,000) = $3,000, and the average cost per cake falls to $3.00 because the fixed rent is spread over more cakes.
Worked example 2, splitting a mixed cost. A shop's electricity bill was $1,400 in a month with 2,000 units of activity and $2,000 in a month with 4,000 units.
- Variable rate = ($2,000 - $1,400) / (4,000 - 2,000) = $600 / 2,000 = $0.30 per unit
- Fixed part = $1,400 - ($0.30 x 2,000) = $1,400 - $600 = $800 a month
- Check with the higher month: $800 + ($0.30 x 4,000) = $800 + $1,200 = $2,000, which matches the billCase study
Seen in the real world
This is a fictional, illustrative scenario. GreenLeaf Candles, a growing manufacturer, needed to understand its expenses to survive a busy winter season. The manager reviewed the books and separated costs. Rent and salaries totalled $5,000 per month, remaining completely flat whether they made 100 or 1,000 candles. Meanwhile, wax and wicks cost $3 per candle produced.
By understanding this behaviour, GreenLeaf calculated that producing 1,000 candles would cost $5,000 in fixed expenses plus $3,000 in variable expenses, giving a total cost of $8,000. This clear insight allowed the team to price each candle at $12, ensuring a healthy profit of $4 per unit at that volume once fixed costs were fully covered. The manager then used the same split to find the break-even point. Each candle earns $12 - $3 = $9 towards the fixed costs, so break-even is $5,000 / $9 = 555.6, which rounds up to 556 candles. At only 400 candles, revenue of $4,800 would not cover costs of $5,000 + $1,200 = $6,200, a loss of $1,400, whereas at 1,000 candles revenue of $12,000 less costs of $8,000 leaves a profit of $4,000.
Watch out
Common mistakes
- Assuming all business expenses are entirely variable and will drop to zero if sales stop.
- Treating fixed costs as a per-unit figure that stays the same regardless of production volume.
- Ignoring mixed costs and failing to separate them into their fixed and variable components.
Questions
People also ask
Why is understanding cost behaviour important for pricing?
It shows you the exact cost of producing one more unit of your product, helping you set a price that covers both variable production costs and a share of your fixed overheads.
Are fixed costs truly fixed forever?
No. Fixed costs are only fixed within a certain range of business activity. If your sales double, you may need a larger warehouse, which increases your fixed rent.
How do I handle mixed costs in my budget?
You must split mixed costs into their fixed and variable parts using past data, separating the base fee from the usage-based portion.